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Here we are once again, with the market treading water as we await the results of the meeting of the Federal Open Markets Committee (FOMC), or as we usually say, "the Fed". Fed watchers are rather confident we will see another rate increase on Wednesday. As always, the question is whether this interest rate increase is already baked into current market prices, or whether the market pulls back in response. The huge bullish run we have enjoyed since the election last year seems to have flattened out after the Standard and Poors 500 Index (SPX) hit a high of $2396 on March 1st, slowly declining and closing at $2373 yesterday. Trading volume has also dropped off since March 1st, closing at 1.9 billion shares yesterday, well below the 50 day moving average (dma).
The market futures are suggesting a lower open this morning, so it appears this waiting game will continue today, and probably through tomorrow afternoon.
Economic data have been strengthening recently, but the bulk of the market gains are based on expectations of gains yet to be realized: tax reform and trimming of bureaucratic regulations, to name a couple. Will an interest rate hike dampen that enthusiasm?
I was invited to write a chapter on the diagonal spread for a new e-book that was just published. That will make for good reading while we wait on the Fed.
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The S&P 500 roared higher this week, closing yesterday at a new all-time high of $2351. I must say this has caught me by surprise. Conventional wisdom believes this strong bullish run has arisen from the prospects of individual tax reform, lower corporate taxes, and a reduction in the regulatory burden on business. Each day brings news reports of political resistance to many of these campaign proposals. I think the market has gotten ahead of itself, but the price is the price. My rationale one way or the other isn’t relevant.
The forward-looking P/E for the S&P 500 is now 17.6, the highest level since June 2004. The five-year average P/E is 15.2 and the ten-year average is 14.4. Higher stock prices have been driving this ratio higher because forward estimates for earnings are not growing as rapidly as prices. This suggests that the market’s exuberance since the election may be a bit overdone. In my opinion, there is substantial evidence for a bullish market outlook; I don’t disagree with that assessment. But the prospects of a pull back or correction appear to be increasingly probable.
The S&P 500 volatility index (VIX) rose on Wednesday this past week, but then declined to close on Friday at 11.5%. Wednesday presented a classic VIX divergence, i.e., when the market index and index volatility are running in the same direction. In this case, VIX ran from 10.8% to 12% on Wednesday, while The S&P 500 traded higher by $13, closing at $2349, a new all-time high (until Friday). VIX divergences are high probability indicators. In this case, with a rising VIX in a rising market, a pull back is highly probable, and in fact, did occur on Thursday. The S&P 500 followed through with a lower open on Friday, but then the bulls reasserted themselves and pushed the index higher.
More and more overbought signals are appearing, but markets can and have continued to rise in overbought conditions before. This is where the market adage originated, “Markets climb a wall of worry.” Trades positioned with a bullish posture make the most sense in this environment, but keep your stops tight. The probability of a pull back or correction is increasing, but that may be well into the future.
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The talking heads on the financial networks have been talking about about breaking $20,000 on the Dow Jones Industrial Average for several weeks now. The Dow touched $20,000 this past Friday, but could not hold it, closing at $19,964. SPX broke out to a new all-time high on Friday, closing at $2277. But trading yesterday and today confirmed that the markets remain in the sideways trading channel in effect since early December.
The market’s meteoric rise since the election couldn’t continue, so taking a breather is to be expected. The economic proposals being promoted by the new administration are very encouraging to both small and large businesses. And this carries over to broad consumer confidence as well. All of the consumer confidence surveys are either near or above several year highs.
The S&P 500 volatility index (VIX) has been steadily declining since the first of the year, closing today at 11.5%, levels we haven’t seen since July and August. The common interpretation would be bullish, based on a consensus among large institutional traders for higher markets and minimal need for hedging their portfolios. The contrarian viewpoint would be that this is simply the calm before the storm. I am inclined to the former viewpoint.
In summary, all three market indices, SPX, RUT, and NASDAQ, have been trading sideways for some time and the possible breakouts from last Friday have now been nullified. The inauguration is still about ten days away and we are just starting to see the legislative battle lines begin to be drawn. It isn’t too surprising to see the market take a breather as this action unfolds.
Even as the overall market indices have slowed, the financial stocks remain strong. Some, like GS and MS, have flattened and are trading sideways; SCHW and others continue to climb, but at a slower rate. Buying diagonal call spreads is working well on these stocks, but be sure you know when the earnings announcements are scheduled. Carrying those positions through an announcement is risky.
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President Trump was inaugurated yesterday. Normally, the market would not be too concerned about that event, but this year was different. Trump’s strong talk about trade has the market worried about a trade war. On Friday morning, the markets traded higher until Trump’s inaugural address, then the major indices gave up most or all of their gains after Trump reiterated some of his trade rhetoric. I am presuming his comments are only a negotiating tactic. Business people always ask for the moon, but never expect to receive that extreme. The Standard and Poor’s 500 Index (SPX) opened Friday at $2270, and traded as high as $2277 before pulling back to close at $2271, essentially flat on the day.
SPX has been trading in this sideways channel of $2240 to $2277 since early December. The market has paused to reflect on the probabilities of the new administration’s economic proposals becoming a reality. It is hard to predict how long we may trade within this sideways channel. This market has proven very resistant to bad news, having withstood recent terrorist attacks both domestic and abroad. So I am not in the doomsday camp. This market needs some solid economic news to push it higher, e.g., passage of a tax reform bill. This sideways trading action is also reflected in SPX’s trading volume, which has been running below average all year. This underscores the “treading water” we have observed in market prices.
The S&P 500 volatility index (VIX) declined all of last week, even dipping below 11% on last Friday, 1/13. But the VIX started rising earlier this week, hitting an intraday high of 13.3% on Thursday, presumably reflecting some uncertainty leading up to the inauguration. But the VIX fell Friday, closing at 11.5%, down 1.2 points on the day.
It fascinates me to see the bipolar response of this market to a Trump presidency. On the one hand, his comments about lowering taxes and reducing bureaucratic regulations are received enthusiastically. But some of his other comments, notably about trade tariffs, make the market nervous. Layered on top of these issues may be some concern about the “establishment” politicians resisting the changes Trump has proposed and creating a legislative stalemate.
The overall market has been trading sideways since early December, but we aren’t seeing much negativity in the market’s technical indicators. The dividend yield of the Dow Jones stocks is roughly in the middle of its five-year range. The CBOE put/call ratio is a little high, but this is a contrarian indicator so a high put/call ratio is actually bullish. Consumer sentiment levels are near record highs, and the willingness of consumers to spend money is a basic requirement for a strong economy. Despite the harsh rhetoric and the anarchy in the streets, the Trump administration is creating positive expectations on the part of ordinary working people. Unless we see support levels begin to be broken, we should assume continuation of the bullish market trend.
This market remains nearly ideal for classic delta neutral options strategies, such as iron condors and calendar spreads. A diagonal bull call spread is also a good strategy for stocks with strong price patterns that may be on the verge of breaking out higher if and when this sideways market breaks, e.g., AMAT, CGNX, and BA.
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The implied volatility of the S&P 500 index (SPX) is measured by its volatility index, VIX. Similarly, the implied volatility of the Russell 2000 index (RUT) is measured by RVX and the NASDAQ 100 (NDX) has VXN. Most commonly the volatility indices vary inversely with the values of the corresponding index, so higher levels of volatility normally accompany lower prices on the index. When one sees a divergence from this relationship, it is worth noting. Today's trading took the broad market indices higher, but their volatility indices also moved higher - a volatility divergence.
SPX closed at $2269, 0.2% higher, but the VIX closed at 12.0%, for an increase of 4.6%.
RUT closed at $1378, 0.5% higher, but the RVX closed at 17.4%, for an increase of 3.6%.
NDX closed at $4966, 0.5% higher, but the VXN closed at 14.2%, for an increase of 7.4%.
One interpretation is that the large institutional players were buying protection and driving up the option prices at the same time that the index prices were trading higher. Perhaps they are concerned about a pull back? That wouldn't be too surprising. After all, SPX is up 8% since November 7th and the small caps are up even more, with RUT up over 18%. So a bit of a breather would not be too surprising. It could be argued that this increase in volatility is simply reflecting the consensus of professional traders who are expecting a bit of a pull back after such a strong run higher.
So what is the average retail trader to do? I suggest two courses of action:
1) Look over your portfolio and identify the stocks that you think have traded much higher than you think is warranted - of course, that can be a difficult judgment. Sometimes stocks just continue higher in spite of our best judgment. Taking profits on at least a portion of those positions might be prudent.
2) Don't get too far out over your skis. This is probably a good time to wait on the market. Allow some of the Trump euphoria to dissipate.
Happy New Year!
